The Derivative - WTF?! Will 0DTE Cause Gammageddon? With Mike Green and Craig Peterson

Episode Date: March 9, 2023

WTF is “Gammageddon”?  What do 0DTE options have to do with it?  Should I be fearful? Should I be greedy? We’re getting into all of it in this episode where we dig into just what zero days to expiry (0DTE) options are, who’s trading these things, who’s on the other side, and why (and why not) any of it could matter to investors… to option traders…..to the VIX.  On the latest episode of Derivative, Jeff talks with Mike Green and Craig Peterson about what is really happening down in the options weeds as the industry’s newest product makes headlines. During the discussion, the trio covers a range of topics, including why quarterly options may be better than annual, weekly better than quarterly, and of course, daily better than weekly. They talk the decay of options, the participation of retail investors, the ins and outs of gamma hedging, and the similarities between selling calls and selling puts. They also explore the dynamics of gamma explosion and risks involved in trading something which expires before it clears (WTF indeed). So, sit back, relax, and tune in to WTF! GAMMAGEDDON? — SEND IT. Chapters: 00:00-01:30 = Intro 01:31-12:54 = Tier 1 Alpha, ODTE defined, are we barrelling towards Gammageddon? 12:55-26:15 = ODTE options: Who’s buying, who’s selling? & it’s exposure to risk 26:16-41:49 = Do ODTE options dilute the VIX, is it really broken? 41:50-51:41 = GEXs & Gamma: bring on the noise 51:42-01:03:22 = How does it all end? Comparisons of trading volumes 01:03:23-01:06:53 = Crypto Victory Lap? From the episode: Charts in order during episode  Previous episodes with Mike Green: Straddles, SVXY, and (GAMMA) Scalping with Logica’s Mike Green Hedge Funds vs ETFs, Passive vs Active, 70s Inflation vs now, & Commodities vs CTAs with Simplify’s Mike Green Follow along with Mike on Twitter @profplum99 and Tier1 Alpha @t1alpha Don't forget to subscribe to The Derivative, follow us on Twitter at @rcmAlts and our host Jeff at @AttainCap2, or LinkedIn , and Facebook, and sign-up for our blog digest. Disclaimer: This podcast is provided for informational purposes only and should not be relied upon as legal, business, or tax advice. All opinions expressed by podcast participants are solely their own opinions and do not necessarily reflect the opinions of RCM Alternatives, their affiliates, or companies featured. Due to industry regulations, participants on this podcast are instructed not to make specific trade recommendations, nor reference past or potential profits. And listeners are reminded that managed futures, commodity trading, and other alternative investments are complex and carry a risk of substantial losses. As such, they are not suitable for all investors. For more information, visit www.rcmalternatives.com/disclaimer

Welcome to The Derivative by RCM Alternatives, where we dive into what makes alternative investments go, analyze the strategies of unique hedge fund managers, and chat with interesting guests from across the investment world. Hello there. Welcome back. Welcome old and new. Welcome red and blue. Welcome to Zero DTE Traders and welcome

to Trend Followers. We'll be excited to hear we have Marty Bergen, president of Dunn Capital, on next week to talk about four decades or so of trend following by that program. Go subscribe so you get it as soon as it drops. On to this week where we ask what in the actual F is all the hubbub about with Zero DTE options. I'll admit I was a little bit on the side of it's just noise, it's no big deal, but had my eyes open a bit on this pod with friend of the pod, Mike Green, and Tier 1 Alpha's Craig Peterson, who came with data and graphs showing it's not just zero DTE is growing, it's that everything else is shrinking. What? Send it.

This episode is brought to you by RCM's Outsource Trading Desk. You know that RCM does the clearing and execution for several ETFs and mutual bonds utilizing futures options and VIX. Yeah, check it out at rcmalls.com. Now back to the show. Welcome. We've got Mike Green here. And of course, I'm going to forget Craig's last name as I'm introing. Craig, what's the last name? Peterson. Peterson with an E.

That's right from when I was emailing you. So Mike Green of Simplify, Craig Peterson of T1 Alpha. Is it T1 Alpha or Tier 1 Alpha? Tier 1 Alpha. We go by both, though. Go by both. So I think our listeners know Mike pretty well. We've done a few podcasts.

We'll put those in the show notes. But Craig, why don't you give us a quick little intro of yourself and what you're doing at Tier 1 Alpha? Yeah, so as I mentioned, my name is Craig Peterson. I'm the CEO of Tier 1 Alpha. And I partnered up with Mike about a year ago, and we had a shared interest in a lot of these flows models, specifically in the options space. So since then, we've started a daily newsletter that we put out talking about options, market breadth flows. Um, and yeah, that's, uh, that's kind of the quick story there. Yeah. And for anyone who hasn't checked it out, the, uh, give us the URL t1alpha.com. It's a www.tier1alpha.com.

Tier1alpha.com. Like, yeah, sign up. I think I have a subscription. We were just talking before we started that I haven't quite used it as much as I'd like, but when I first logged in and I was banging around the tools, it's pretty cool stuff. Yeah. So one of the key things that we've done, and I'm sorry, this is Mike Green interjecting. I know this is probably audio for a lot of people, but one of the things that we've done in the last year is move the emphasis away from an app-based tool that could be used, although that will ultimately be available to institutional users, and really turn it into a letter that's capable of going out that allows me to actually process a lot of the stuff that I'm looking at from a daily basis in terms of positioning, particularly as it relates to short-term option phenomenon.

And that basically is the synthesis that Craig or I are pulling together that's allowed us to very quickly expand it without dramatically having to expand the expense associated with it. Because running these things is hard. Running it on an app basis where you have to constantly maintain both the software and the data is actually really challenging. So we're in the process of figuring out ways to make that economic. But in the meantime, there's a newsletter that goes out that we encourage people to take a look at. I love it. So that's for people like me, like, don't make me go into the tool and bang around and try and find the info I need. Here it is summarized. Here's what's important today from the data we're seeing. Yes, exactly. So the learning curve on all these things, as you know, anyone who's switched over to a Bloomberg or

anything else, the learning curve on these things is really steep. And often for the person who's just trying to get some information, you're much better served by having other people do that analysis first. Love it. So yeah, I think we'll, as we go throughout, we'll touch on some of that analysis that you've been seeing with the tool. But so we buried the lead. We're here to talk about zero DTE options. What the F, you guys look like polite Midwestern types to me. So I'm not going to use the actual word, but what the F is going on with these things. It's in the news. It's everywhere. Half the managers I talk to say it's no big deal. Half say it could be the next ballmageddon. I like the new term gamageddon.

It's a little more fun. So before we dive into all the pros, cons, what's going on, let's do a little fact searching mission here first and kind of level set of exactly what these are and what's going on. So when did they start? Let's start there. So we've always had zero data expiry options, right? Any option that is approaching its last trading day is, by definition, a zero-day to expiry option. Historically, options were available initially on a quarterly basis on indices and individual stocks, and they became available on a monthly basis. And then as we move to weekly, if you just think mechanically about what happens, the monthly and the quarterly have the same expiry date. Moving to weekly dramatically increased the number of options that were expiring that same day.

Seeing high trading levels around those options, the CBOE, the Chicago Board of Options Exchange, introduced or began to explore the idea of introducing daily expiry options. I believe it was 21 that they went for initial commentary. And then I believe it was, correct me if I'm wrong, I think it was April of 22 that they introduced daily expiry options on indices. There's really nothing yet available on individual stocks. And we're starting to see the number of indices that zero data expiry options are available expand due to the obvious demand, right? These have now moved from, I want to say, around 5% to 10% of average daily volume, obviously contingent upon, you know, that's not really

saying much given that an option has 22 days of expiry on a monthly basis. So you would expect them to be around 5% normally. They've now exploded to somewhere between 40% and 50% on any given day of the option trading activity. The volumes are actually tied to the options with zero data expiry. So what does that look like? But the overall volumes have remained the same, or has that all been added to? So the volumes have grown and actually Craig may have a chart that he can pull up and show this, but what we've seen is initially the volumes grew a lot and now we're seeing an increasing level of replacement of longer dated options. Effectively, there's two separate dynamics that are going in. One is that strategies that sell

volatility, sell options, have recognized that since that is a high probability trade, you want to do it as many times as you possibly can. So any strategy like a quarterly call overriding strategy is probably better done at a monthly level. A monthly call overriding schedule is probably done better at a weekly basis. A weekly call overriding strategy, you see where I'm going with this, done better at a weekly basis. A weekly call overriding schedule, you see where I'm going with this, is better on a daily basis, right? And so that's actually where we're seeing the majority of the actual quote unquote demand for these products is for selling these options on a daily basis. They're doing it in smaller size than they would for a monthly option or a quarterly option, but it allows them to do the

trade over and over and over again. Since it's a high probability event, it ends up creating a higher Sharpe ratio or win ratio overall, right? Any given month, it's 50-50 basically, are we going to outperform? But if you continually repeat a process that is slightly better than 50-50, it's actually more like 80% probability, you're going to end up with super high sharp ratio assets. Which to me, that's like, okay, I just have added way more chambers to the Russian roulette gun, right? So is it still, is a terminal break even proposition, right? Like you're still have a, or no because the is the risk less because they're daily. So so if you properly size them, the expected return of selling these options is higher if you do it on a daily basis.

There's two reasons for that. One is because options decay exponentially. Remember, they're going from, you know, value to no value by the end of the day. You basically don't have to worry about how is the market pricing, the implied volatility for the remainder of the contract, et cetera, things that have historically added variability to those sorts of strategies are removed when you engage in this sort of dynamic. The problem, of course, is that it is much more coin flip like, and therefore you want to reduce the size of each individual trade relative to the notional in your portfolio in order to properly size this. The challenge, of course, is that we don't know if people are actually doing that,

right? The temptation's always there to go out and push this once it's really working. And Craig, if we put you on the spot there, were you going to pull up a chart? I made you the co-host if you had one. Sorry, go ahead. For that particular chart, I might need a moment to pull that one up. And then if my brain also goes through like, okay, it's better, right? Monthly is better than quarterly quarterly weekly is better than monthly daily is better than weekly why don't are we going to go to hourly are we going to go to

minutely is that a word minutely yeah um well certainly i mean that's the theory of complete markets right is that all securities should be available at every possible moment the challenge is twofold one is from regulatory framework, these options are not actually cleared before they're expiring, right? So in a weird way, when you have T plus three settlement, et cetera, you're actually looking at a scenario in which these options are long dead by the time somebody actually says, okay, by the way, I did this trade and it shows up on my margin reports, my capital reports, et cetera. That is something that should always be concerning. Sorry, but is that part of the demand that like, hey,

we can kind of do this trade outside of our normal risk metrics and everything that gets looked at by our board and whatever, like we can kind of do this before it hits the books? I would have to believe the answer to that is yes. Yeah. And then my second thought there, did that come from crypto, right? It sounds like SBF of like, hey, we don't need T plus three. We don't need all this fancy clearing stuff. We can do it in real time on the blockchain. I don't know the answer to that, but I'm wondering if crypto started where you're saying there's always been zero DTE. Yeah, there's always been zero DTE. So I don't think that that's particularly important. I think the scale of it has become increasingly important. Right.

And so the issue is not dissimilar. I just want to be very clear that I'm using this as an analogy, not as a direct comparison, but the misrepresentation by Bill Hwang of his exposures to his prime brokers is made much easier if products expire before they clear. Right, right. He was able to do it without this. Right. He did it the old fashioned way.

He just lied, right? This technically skirts the rules. And so if there's going to be a change, I would expect that this forces elements of faster clearing of trades, or we're going to find some restrictions placed around it. In terms of nominal size, and that would be backwards looking, they'll always they're like, okay, you're getting audited. How many of these did you do? What was the nominal at the time? Yeah, that's you know again like from a prime broker standpoint it's very tough to monitor these types of exposures you know there's interesting questions of should you have to post collateral upon executing the trade you know does it if you

remember way back in the dark ages when you had to fill out a very complicated form for your brokerage statement for your brokerage account in order to be able to trade options, you had to agree to all sorts of dynamics in terms of what your risk limits were, et cetera. Again, this is really hard to maintain with structures that expire before they clear. I still have a problem with that. I still can't in my 401k. I want to be able to sell puts on some things, right? I want to be able to do, and you still can't do that in a 401k. They won't let you have level three access, whatever it's called.

But I digress. Moving on to who is buying these things? Who's buying, selling actually, as you're saying, but who's doing the majority of the selling? I think a lot of the articles are like, oh, this is going to blow up. This is retail getting in there. But most of the stuff I've read is like,

it's not retail at all. Retail hasn't even picked up on it much yet. So what are your thoughts on the who? Craig, you want to take that one? Yeah, sure. So I think the retail involvement, it's definitely there. There was a JPM report out a couple of months ago, and I believe they were talking somewhere in the range of like 6% and 7% of zero DT interest is coming from retail, which isn't enough capital. Well, you wouldn't think it would be enough capital to drive up the type of volumes that we've been seeing. So I think this is definitely institutional money coming in. And what's kind of interesting about this whole

conversation around zero day options is I don't think a lot of people have really been asking, where has the capital been flowing from? where has the capital been flowing from? You know, and especially where's the capital been flowing from? There you go. Perfect. Well, you know, if this is if this is institutional money, is this going to be fresh capital or is this going to be pulling from a different strategy? And in this case, I think, you know, it's being pulled from contracts further up the chain and for, you know, further down the expiry line. And in particular, I think a lot of this capital flow

is coming from 30 day contracts. So what's interesting about 30 day contracts, well, those are the ones used to calculate the VIX. So we've actually done some work on this and we've modeled this going back to 2018. And this is actually the dynamics that we're starting to see. So you lost me there for a second. So the dynamics is, so it's institutional. What's the normal percent of retail? Do we know those numbers? So if it's six to seven percent of zero DTE, what's the on all the rest of the volume? Is it 10, 15 less? You know, I don't actually have those numbers. I'm not exactly sure. I don't know if, Mike, you have some insight on that.

Yeah, I know. I mean, the quick answer is, is that it's probably not all that dissimilar. And we don't have the firm data on that there's ways that there's ways that you can attempt to isolate that by looking at order size although that is increasingly less relevant uh in terms of isolating retail versus how it's been historically simply because we'll split orders up seamlessly using technology right yeah yeah um so there's all sorts of you know this is one of the real challenges, when you go back to something that isn't cleared before it expires, like the data is just not great, right? We really actually don't know a lot about this. This is brand new stuff. I loved the description that you gave earlier. I hadn't heard that phrase

gamma getting, but that is actually a very good description of kind of the risk that exists around these. Because if you think about a lot of what we talk about at Tier 1, and we're certainly far from unique in talking about these dynamics, when you say who's buying, who's selling, if the vast majority of the activity is selling, that seems impossible because every buyer has to have a seller, right? Yeah. The reality associated with options is that one of the critical innovations that was introduced by the Black-Scholes model in the early 1970s

is the ability to create synthetic options through risk-neutral arbitrage, right? Put call parity giving you a way to allow a market to be imbalanced. If somebody wants an option, I can theoretically, synthetically create that through a combination of futures, right? Just futures? Yeah, a delta hedge, right? So if I've sold a call option with five delta, my hedge ratio is going to be 5% of an underlying future. If I sell an option with 25 delta, I'm going to have 25% of a future that I want to short against that, for example, to keep me neutral in the market. And then I'm going to,

as frequently as I can economically, and the really good market makers at this point, in the microseconds that's measured, will continually delta hedge my book in order to keep me from having a directional point of view, which they could care less about. I mean, I spend time pontificating on that. You may spend time pontificating on that, but I guarantee you that a Citadel market maker does not care. The last thing they want is exposure to the market. They want to capture the premium associated with the market making activity. Right. They'd rather not move after they sell you that option.

No, exactly correct. So when we talk about who's on the other side of it, the easiest way to think about what would happen is I decide to go into the market, I own the S&P outright, I want to increase the income associated with that by selling options against it. If I were doing a call overriding program on a monthly basis, I might write it against 100% of my notional, capping my return for the month, but giving me significant income as I go through it. If I move to a daily strategy, I might want to reduce that exposure to say 20% of my notional so that I get multiple shots on goal at any point in time and I'm scaling that up. If I do the math on what that works out to,

it's about a 35% to 40% premium by doing it every single day as compared to on a monthly basis, even at the lower notional level. So it's a higher income strategy. It's got more diversified observations, et cetera, making it, as we talked about, a better quote unquote trade. And we're talking like a CalPERS, like some big institutional... Any institution could do this, but all the big institutional desks ranging from Canadian pension plans to multi-strat hedge funds are rolling out strategies around these types of dynamics. And the whole idea is like, hey, I'd love to make 1% on my beta today, right? So if I'm fine capping it at that 1%

or whatever the number is, 1, 2, how far, what's the average distance of these strikes? Do we know that data? Off the top of my head, I don't think we know that. But Craig, on a daily basis it on 20% of your notional and you collect, let's say 75 basis points or 100 basis points on any given day, and that adds up really fast in terms of the income exposures. And yes, you're going to lose some, you're going to get hammered in terms of the individual option that you may have sold. But again, remember, you own the underlying, the worst case scenario for you is markets go down. The markets go down and you didn't make enough income to offset the downside risk, right? Right.

And what, so on that side, it's the CalPERS, multi-strat hedge funds, pod shops, whomever that's saying, okay, we can earn a little bit of income here. We've already got the beta. We're good. But right, is that ignoring totally the concept of you make most of your money on the big updates? If you're truncating the right tail, essentially, are you... Again, actually, so stop and think about that dynamic because I've only written the option against a fraction of my underlying notional. That big update is less of an issue for me now. I can have 80% participation in that big

up day as compared to only participation up to the amount that the option I've sold against. Right. If you truncate and only make 80% of the upside over years and years, what have you done to your overall beta exposure? Have you really hurt yourself, your ability to get the compounding and the outlier gains. Well, just remember, though, that you're exposed to that risk already with a call overriding strategy. And so on any given day, the risk is actually less of that under these types of strategies. The issue here, from my perspective, is in many ways, and this is completely consistent with the theory of options and complete markets, right? This is on net a good thing, right? It is what we would expect to see in an environment in which these sorts of strategies become available.

The risks that emerge is that exactly what you described, a Gamma Geddon type event, that markets become discontinuous, right? If an event occurs that causes markets to fall sharply, the risk now sits not so much with the overrider, right? It's not the institutional trader who's doing what they've always done, but actually doing so now in a way that is in many ways more responsible, right? And reflecting less risk. The bigger issue that we actually are sitting with is actually at the dealer or the exchanges. And but on the Gamma Get Insight, so let's just explain those dynamics a little bit. So, and we're talking Citadel, Susquehanna, like who's on that market maker side, those big, big, huge.

Yeah, no, I mean, it's and by the way, they are really good at what they do. Right. So I just want to be very clear that I'm not, you know, turning around and saying Susquehanna or Citadel are being really irresponsible here. But the risk that exists, as always, in options is that you can't actually hedge that exposure. Right. options is that you can't actually hedge that exposure, right? So an instantaneous gap of a large quantity, given the volume of these that are outstanding in the open interest that sits there, could create significant risks for the actual exchanges and market makers themselves,

setting up conditions that look more like an AIG failure than anything else. And the mechanism there is as the market's going down closer to the strike of that zero DTE, the dealers are shorter and shorter, the gamma's going higher, right? There's short gamma in that scenario? Right. And they have to sell more and more, which creates a cascade. They have to sell more and more exposure, right? So again, this is less of an issue as it relates to the net selling of calls, et cetera. But it really does tie to this idea of

you've now got instantaneous exposure to a market that requires markets to be liquid if you're going to properly hedge it. Right. Again, these guys are really good at this. Absolutely no debate that that's the case, but anytime you're dealing with options and the hedging dynamics, the real risk that exists is similar to what we saw with XIV. That's why people have drawn the analogy to XIV. It's a move of a large enough magnitude that happens basically instantaneously that causes the market's ability to execute these trades to break down. But this entries a different concept, right?

Because the market maker in this case has to buy that delta hedging back at the end of the day. Or do they? I guess that's the confusing part of like, I'm cascading down, but then I'm going to cascade back up. Right. So let's just actually walk through exactly what would happen here. So I own the if the market goes up, right? And they lose money if the market goes down. So what do they have to do? They have to

sell futures in a Delta hedged equivalent to the call exposure that they have, right? That in turn means when I initiate that call option, I sell the call option, the dealer is now selling futures, pressuring the market lower. What happens to the value of the call if the market is pressured lower? It falls. It goes lower, which now means the delta, which means market makers start buying back that exposure, causing markets to rebound. This is the pattern that we're seeing intraday over and over and over again, where markets are transiting multiple times. We actually highlighted this within Tier 1 Alpha. I think it was yesterday or two days ago, we saw the market move five separate times, nearly 1% intraday, only to close. I think it was, correct me if I'm wrong,

but 30 basis points lower, right? So traditional measures of volatility says nothing happened. And yet intraday, man, that's a crazy amount of territory to cross. And even the vol of vol statistics might not capture that, right? Because it's all intraday. It's really hard to actually force those levels significantly higher than the realized components, right? I mean, imagine a scenario in which I, as a market maker, decided to try to raise the price of the implied volatility to those levels. Competition would immediately come in underneath me and undercut me. Yeah. come in underneath me and under and you know undercut me yeah and then and so craig you'd mentioned before this is doing some weird stuff to the vix because

that's the 30-day options are calculated on so i think that some people's worried worry uh especially in some of the circles i'm in of like, hey, we're using the VIX as a hedge and the convexity and all this stuff. I guess, is that VIX property getting removed because of this? Yeah. And I think there's some valid points around, is the VIX broken? That's been the big conversation. And I think this really all started back in 2020 with COVID and we saw the VIX spike to, you know, above 80. And since then we've seen premiums at those 30-day SBX contracts stay really elevated and they really haven't come back down. So what I think is interesting with this related to zero-day options is as those premiums have

gone up, volume at those 30-day strikes has gone down. At the same time, we've been seeing volume increase at these shorter-dated contracts. And what about the prices at the shorter-dated? What does that even look like? So in your example, Mike, of the, using Mike's example, what would I be selling that at? Well, let me just kind of frame it like this. So one 30 day contract, there's about a 20 to one ratio. So one 30 day contract costs about the same as 20 zero DTE contracts. So I think there's a lot more, you know, potential strategies

that you can deploy with the same amount of capital just by moving down the chain through expirations. And the other thing that happens on this point, right? So remember, if even a fraction of these options

are moving to hedging the specific event, right? CPI released today. Therefore, I'm going to hedge on a one-day to expiry option as compared to a 30-day to expiry option. It really doesn't capture today's move at all, right? Remember what you're doing with that 30-day option is you're capturing events that occur over the next month, right? Craig just shared the chart looking at the option volume by expiry. And listeners, if you're listening, go over to YouTube, the derivative there,

you can see all these pretty graphs here. You can see all the pretty graphs. So part of what's being shown here, this is showing the buildup of it. I think Craig's going to show another chart that shows the absolute level of the volume that's occurring at the 30-day. That has declined as basically people have said, wait a second, it's much more efficient for me to hedge the event that happens tomorrow, right? This demand really exploded around the October CPI release that caused the market to move like 5%, right? It's been interesting. I've actually been a fairly consistent seller myself against those types of prices, because you'll see the single-day vol respond to that spike into the one-day forward vol has in many situations spiked

to north of 40. That's almost impossible to make money on that hedge, right? And as a result, markets have failed to deliver on that. In turn, we're now flipping around and seeing people basically move to what one of our colleagues, David Pegler at Tier1, called comfortably numb. The Pink Floyd song basically has taken over the market where people are like, man, I don't even know why I bother hedging anything. That seems to have been the overall takeaway on a lot of this stuff. But the bigger thing that I would argue that it's causing is as we deteriorate, and Craig, can you pull up the chart that shows the actual volumes at the 30-day? It may take you a moment, but that's totally fine. So when you think about what's happening, so here we go. This is the volume used at the expiries in the 30-day calculation. This is

a chart I wanted you guys to see. So initially, we were seeing increased volume activity at those levels in the aftermath of COVID, although they never fully recovered. The high level of implied volatility meant it was less attractive to hedge using volatility than it was prior to COVID. But what we're seeing now is this deterioration in volume there. Effectively, that's the hedging point. We're now not seeing significant amount of demand for those tails. That in turn causes the VIX to contract because the VIX itself is heavily dependent on those tails. This is what you've heard people refer to as the falling skew in the market. That in turn turns around and shows up in metrics like financial conditions indices

as saying the market is getting much easier, right? Financial conditions are loosening. I'm not sure it says that at all. It actually is just telling you that there's less demand to hedge at the expiries that are used in those calculations. But you also said something in there, there's less demand overall to hedge because people are comfortably numb. That's kind of counter to some of the narrative around this of like, oh, now everyone's perfectly hedged with their zero DTE and everyone's kind of perfectly hedged and a hedge market doesn't fall and all that kind of narrative. Right. It's the overcrowded bar and L for all, right? Nobody goes there. It's too crowded.

Right, right. Then how did it get so crowded? This is, yeah, this is super interesting chart here. So listener, we're looking at 30 day and it's surprising in 22, right? That it didn't spike up back to normal highs when we're down 25% at the lows or whatever? Yeah, but it completely failed to work, right? I mean, that was part of the challenge that we experienced is the elevated level of the VIX going into 22 meant that it was very difficult to hedge properly using options. And now, can't you flip this and say, well, now that's all sort of reversed and the VIX is at a more normal level and we've rebounded a little bit. So it's somewhat back to normal,

or you're seeing in these charts, no, not back to normal. So I would argue that it's no, not back to normal, but that doesn't necessarily mean that it's quote unquote expensive either. Right. The level of the VIX, this shows the average contract price, you can almost reverse engineer this into the level of the VIX itself. You know, north of 20, historically has represented fairly significant fear in the market. If you think about the distribution of equity volatility, it's a very bimodal distribution. Bull markets, you tend to average 12 to 14. Bear markets, you tend to average 20 to 25. As a result, the overall average for the VIX is around 16, 17, which roughly reflects the standard deviation or realized volatility of the S&P, somewhere around 15, 16%.

When we talk about those averages, we're basically splitting the market into two separate components. What we have seen since 2020 is by and large a market that is consistently pricing in the high teens to low 20s, much more consistent with a bear market, even when markets were printing all-time highs. Now, with that said, we also have dynamics of skew, dynamics of realized volatility that are much higher than we saw in, say, 2017. While the realized volatility is that we're getting in the current environment, I think 10-day realized vol is about 13.5 right now. If we look at those same metrics under the lead up into volmageddon in 2017, we had like four. It was a fairly common number to realize volatility as the huge supply of vol

was going into the... It wasn't like 70 some days. I can't remember the exact number without a 1% move. Yeah. Craig, can you pull up that chart that we posted in today's piece, looking at the share of days? Because this is one of these fascinating sort of dynamics. This was actually... Sure. Yeah. Give me one second here. All right. Craig, you guys wonder why the service is free. And while you're doing that, what are your thoughts on what it does to the upside spike component of the vault, right? So if we say like in these normal times or in these kind of without an event,

I can see what's happening. Like, is it possible that it lowers the ability of those 30 days to that the zero DTE lower the ability of the 30 days to spike that the zero DTE lowered the ability of the 30 days to spike and thus the VIX to spike? So the quick answer is, I don't know, right? Because obviously markets have to be forward-looking as compared to backward-looking. The real risk that I would suggest that we face though, is that when we have the type of dynamic that we're highlighting, where increasingly people are using very short dated options to hedge, is that you get a delayed reaction to something, and then everyone's scrambling for it. So Craig is showing the chart right here that's looking

at the share of days based on absolute returns. So just to very quickly orient you, each day, regardless of whether the market goes up or down 25 basis points, we're treating those as the same. So down 25 basis points is the same as up 25 basis points, down 25 to 50 is the same as up 25 to 50, et cetera. It's just a way of centering against that distribution so that we don't have too much information on an already crowded chart. David Sherman You'll notice that the blue line here, which is the less than 25 basis point days, in 2017, we saw something almost completely anomalous.

We had almost 70% of the days in 2017 in the lead up to the whole, again, where the market just moved less than 25 basis points. This was a key component in my construction of the trade around XIV that led me to realize that the reason we were seeing such low volatility and low correlation was because of the supply of volatility. It had effectively become a self-reinforcing loop. What's so interesting about what we're experiencing right now is that we're seeing extremely elevated levels of 100 basis point days, right? We're now into, you know, kind of four months from the lows in October. Well, you know, after four months, and we're still seeing that 100 day moving average of moves plus or minus 100 basis points, much more consistent with levels from major bear markets like 2000 or 2008 than anything that even

looks like the 1970s, for example. It's a very different structure to the market. And to have people feel this complacent in this type of environment, to argue that financial conditions are easing dramatically, feels very off to me, at least. And I could argue that, yes, but because it's so steady at that level is why vol is not higher, right? If you're moving around in that higher level, but you don't break out of that level, then volatility kind of by definition is, right? If you went down 1% every day, vol would be low. If he went down 1% every day, vol would be somewhere in the neighborhood of 14%, right? Right. Mathematically, not real world.

That's just pure math, right? That hits on a really important distinction, which is the difference between variance and vol, right? So, you know, when you have a down 4% or an up 4% day, that has a huge impact in terms of the calculation of realized volatility, variance, et cetera, even though it can average out, right? Those types of spikes are something we really haven't seen. And that is, again, it goes back to exactly the XIV type dynamics. If you think about that negative dealer gamma that causes dealers to be forced to hedge in a pro-cyclical fashion, the market goes down, then they have to short more, right? That's momentarily removed by the zero data expiry options, as I was just describing,

because it effectively creates a localized gamma positive position against a overall negative position. And, you know, we've described it at tier one is thinking about it almost like a mathematical order of operations, right? Or a to-do list from your wife, right? What do you do first? The things that she says must be done immediately, right? And then you do the next thing, right? So the gamma that's tied to options that expire that day basically become the highest priority activities. And so you focus on making sure you protect against those scenarios much more so than you do the overall picture, at least in terms of the intensity. Perfect, Craig.

Right. That's a good way to get fired from Susquehanna. Like, oh, I was worried about the 90-day option. So I was dealing with that and forgot about all our exposure at 3 p.m. Perfect. So, Craig, why don't you talk to this chart very quickly here? Yeah. So essentially what we're seeing is, oh, I switched that over. So essentially what we're seeing is the shorter data contracts, the shorter they are, the closer they're moving to, you know, what Mike described as this kind of positive gamma pocket. And you have to understand, too, that when we talk about zero day options, a lot of time we're talking about the volumes and the relative volumes for, you know, out of the total volume. But the open interest is still really packed in the monthly and quarterly expirations. So that's why you see, you know, when we look at the total framework of the SPX options market, the gamma profile

is much different for all expirations versus the shorter dated ones. The other thing that jumps out of this chart, you'll notice that the gray line, which is the aggregate exposure and the blue line, which is the beyond 30 days, highlights another feature that is a residual from 2022, which is people are largely hedging using spreads as compared to outright. What this is telling you is that the dealers themselves can be exposed to those gaps that we were talking about before. You see that with the purple line here where there's that immediate exposure. But in general, the market is underprotected against a significant downside move. There's very few players out there who are saying, my gosh, we could have a crash of 87 type dynamic, right? We heard that over and over and over again in 2022. Oh my God, the markets are going to crash. What you're seeing with this type of exposure is

basically nobody's hedging against that anymore. What are your theories on that? It didn't work, right? I mean, there's only so much pain that people can take before they turn around and they say, okay, let's be more cautious about this type of exposure. And again, that's almost kind of the worst case scenario. It's not that people are not hedged because they feel confident. It's that people are not hedged because they're exhausted from spending money on protection. Which typically or historically has led to the very need for that protection, right? It does tend to have a nice correlation with it, yes. Yeah, the timing is the tough part there. We should explain GEX here and gamma exposure, right?

So we're saying as the market rises, the... Craig, why don't you go ahead and explain it in more layman's terms of what we're looking at in terms of GEX here. So when you think about the dynamics of GEX, what we're referring to is gamma expiry exposures. If a dealer, going back to everything we've talked about here, if a dealer has sold an option or if a dealer has purchased an option from a counterparty on a net basis, because again, unlike regular markets, you tend to have an awful lot of imbalance. Everybody wants to hedge Tesla. Everybody wants to bet against a bearish outcome. Everybody wants to overwrite calls. There's an awful lot of everybody's that tends to happen

in the option space, right? When the dealer takes the other side of that, what we're highlighting here is what their exposures look like to changes in price in the underlying. And so when people are hedging their exposure using put options, the dealer has sold that put option and Delta hedged. They're now exposed. If they've sold a put option, their risk is markets go down. They will sell futures in a Delta hedged exposure to that. As the market goes lower,

those put options move into the money, they move towards Delta. That means the dealers have to sell more. Go ahead. I was just going to say, it's fair, as I'm looking at this chart, all expiries, currently the deals are short 420 billion in gamma, or they have $420 billion to sell. And then as we move to $3,800 strike, they have like $1.3 billion to sell. So that's that cascading effect of like, as the market goes further and further, they have more and more to sell. What's interesting here is it starts to tick back up. So it's not an infinite cascade into oblivion. At some point,

why does it tick back up? It remains negative. I just want to be clear on that. But when people have hedged by buying a put spread, for example, then the dealer is short the near the money strike and long the out of the money strike, which means as the market moves up or moves further down, they start to gain delta from that lower strike. So they don't need to hedge nearly as much. Does that make sense? Yep. Yep. And so if you look at this picture, it literally looks like the payoff structure associated with shorter call spread, shorter put spread. Right. And then this also tells me of like, this is back on the, like, this doesn't matter. Look at the zero day line. There's not all that much gamma there.

Like it's not going to move the needle. Absolutely correct. And this is one of the reasons why, you know, we've seen fewer examples of the market kind of melting up above that 4,100 level, you know, just mechanically as the dealers, if I have written calls against my underlying position to the dealers, so the dealers are net buyers, as we move to that point, the dealers themselves basically are now in a Delta one situation. They don't have to worry about chasing it. That creates conditions under which they're going to end up selling exposure in the market as it moves higher, pushing the market back lower. What do you say to people who basically

look at all this GEC stuff and say, this is, they probably wouldn't say garbage, but this is noise. You can't really get the needed data out of the, right? Because how are you getting this? You're getting it from the actual prints at the end of every day, right? Yeah, no. So first of the, right? Because how are you getting this? You're getting it from the actual prints at the end of every day, right? Yeah, no. So first of all, I would agree with them that there's a lot of noise in this data, right? I just want to be very clear that this is not a magic solution to how to time markets or anything else, right? Right. Some people on Twitter have put out signals and whatnot based on it. Yeah. And we actually believe that you can do that, right? And there's pretty good evidence that when you move into a positive dealer regime, that the volatility falls, as you'd expect.

When you move into a negative regime, the vol rises, as you'd expect. The zero data expiry options is basically the market's way of saying, aha, let's make it more complicated for you, right? And that's half the fun, is that the puzzles's way of saying, aha, let's make it more complicated for you. Right. And that's that's half the fun is that the puzzles are always changing. So having dissected components of this and understanding how it's work and try it, how it works and try to figure out what the risks that that creates are. That's that's really the fun in this process. What I would suggest is it is twofold in response to that. One is, is that that's absolutely correct. There's always going to be far more variables than we can isolate in any one analysis, right?

But the second is that if you actually believe that these markets are getting thinner and less liquid and the aggregate supply of liquidity into the system has fallen, it makes perfect sense that the importance of these types of activities, this hedging activity, is going to have a larger impact on the market itself. And the evidence for that is almost incontrovertible at this point. And that's back to your whole passive thesis. That's certainly part of it. It's tied to the changing market structure, right? So we've seen everything ranging from the quantity of liquidity that is supplied at any given price has fallen dramatically. That means markets are more likely to move in response to a large order coming through. And hedging certainly

qualifies as that as it's become more and more concentrated in a limited number of players. And Craig, do you guys run this on Tesla and on individual names or no, it's all indexed? Craig Bauer We can run this on everything, but I have found that the biggest impacts come from SPX and that's just by pure size of the options market. So although there is some gamma effects on single stock options, I think it's broadly more important to track it at the index level. And the other aspect of that is when we're talking about single stock options is these call overriding programs. And it's a

little bit, it just makes the data a little bit more noisy. So, you know, to Mike's point, there's definitely some assumptions in these types of models. But that said, I do think they do a reasonably good job at, you know, working as a proxy for what's actually happening in the background. And we've shown that through our back test, through looking at realized volatility and different regimes. You know, we see a pretty direct link. And then help me understand, because we're saying, I guess it's the same, but we're saying there's all these vol sellers that are emerging and that's part of this data. But when I think of a vol seller, I think of them selling puts. This chart and what we've been talking about is they're mainly selling calls.

So they're short volatility mathematically in both cases, but not the downside volatility, I guess. So how do you think about that? Do you see most of the selling, institutional selling of the zero DTE or all the whole expiries for that matter is mostly call selling? I'm not sure, but I'm going to let Mike take a stab at that one. So the quick answer is- He's going to throw the grenade over to you. Yeah, exactly. You're always going to see more call selling than you'll see put selling for the fairly obvious reason that if people own

the underlying, theoretically, it is a less risky trade to try to earn a little bit of additional income by foregoing some additional upside. Remember that put call parity tells you that mechanically though, selling calls is writing puts, right? I am exposing myself to all the downsides. So it's not really all that different. And that's one of the things that dealers are actually taking advantage of, right? That allows them to say, wait a second, there's an excess of demand to sell calls because people feel safer with that sort of exposure. They've already accepted the downside in their portfolio.

They're willing to give up some upside. Well, again, that's, I mean, mathematically, it's identical to selling puts, but it doesn't feel the same. Preston Pysh, Yeah. Nick Neuman, And then that same concept, can't the dealer, instead of doing all the gamma hedging and causing that cascade, could buy the zero DTE puts? Preston Pysh, They could, but who would they buy them from? Nick Neuman, Yeah, from themselves.

Preston Pysh, Right that, like, again, remember, they're there to facilitate liquidity in the market, not to demand liquidity from the market. The problems emerge when dealers are forced to demand liquidity from the market, which is the type of dynamic you're talking about with a Gamma Geddon or Volumageddon type component, where suddenly the market gaps and they're left to scramble and say wait a second i need to hedge right that exposure is the scary one um our friend said francis who i think you know um he was telling me you guys used to bloomberg chat a lot but um he was saying a lot yeah his theory and i'm putting words in his mouth but he was saying like a lot. Yeah. His theory, and I'm putting words in his mouth, but he was saying a lot of this volume could be the hedging with the options themselves.

So instead of just a normal, the institutional selling and the market maker, you're 2, 3, 4x-ing the number of the options volume and the zero DTE because the delta hedging, the gamma hedging is actually on the same, not the same strike but the same instrument essentially and that's something i was i had not heard a lot about um again uh there's many reasons why i talked to this incredibly bright guy and the his the team that he's working

with are doing great things um so i'm going to reach out to zed right after this call now yeah do it yeah and i could have totally mangled his words there, but it's interesting. So how does this all end? It doesn't. We just keep zero DTs, keep growing into infinity. And the CBOE is the largest company in the world. Well, that would be an interesting outcome, but seems unlikely, right? The argument that I would make is that the GammaGeddon argument or

the Volmageddon 2 type argument is ultimately likely to play out. I just think that people have gotten hyperbolic about these options in two forms. One is the idea that this is just retail punting and speculation. It's not. These are sophisticated players with a very valid reason to be using the products that they're using. And what about there's been talk, it's institutional punting and speculating. Again, I think that hopefully it's been clear that there are very valid reasons why you would actually do this as an institution and do it in a way that actually improves the outcome associated with your strategies. Right. So, like, I don't I'm not going to immediately jump on this and say this is craziness. right? What is a little crazy about it though, is that because it falls into a category of securities that are not clearing before they expire, we actually genuinely don't know the

types of exposures that are being taken on. Yeah, that's the part I hadn't heard before. That's a great point. That's the part that I care about. And I understand that that in turn creates conditions. And this is exactly what happened in the COVID environment. We're becoming increasingly reliant upon the supply of this daily volatility. If people end up getting hurt with these strategies, because markets continually cascade for a period of time, or because vol fails to respond in a predictable way versus historical models, we could see people either get blown out of these spaces or conditions created in which a single

large market maker gets hit by an unexpected action. In particular, I would just highlight the risks associated with a discontinuous market event. Heaven forbid, tomorrow we walk in, China has invaded Taiwan. Joe Biden has suddenly decided that he doesn't want to do the job anymore. Who knows what the answer is, right? An event occurs that doesn't matter what it is that causes markets to gap in a meaningful way. That leaves exposure to the market maker community, to those who might have written puts that we're not aware of because they haven't cleared properly. And somebody can instantaneously blow up, creating a gap in the market, which in turn creates its own fulfilling type dynamic. That's all I care about on this. I actually don't think that this is craziness.

I could care less whether retail is going in and buying call options or doing all that sort of stuff. But for this to be happening in a much broader environment of reduced liquidity and creating the risk that is further increased on events in this, I hate to say it this way, but basically unregulated space, that's all I care about. And it's a big, sorry, it just made me think of something. When back in the XIV, do you think people were selling that in the same way? Instead of selling a call, they would sell XIV? Or was it naked? So, yeah. So, buying XIV, right? Excuse me, buying, yeah. Yeah. So so buying XIV mechanically was selling vol. Right.

And you think they were doing that against a beta position or just eventually it got so big and it was retail? It got big enough that people were taking outsized risks associated with it, right? But again, you and I have had this conversation. XIV was a casualty of an event that occurred because of the Fed, not necessarily because of its own size. It had just gotten to the size that when something happened, it was

inevitable that it would be worse than people thought. That, I think, is a legitimate criticism about what's happening in zero data expiry. We don't really know what the positions that are being taken are. We don't know who's holding these positions. We don't know the extent of the risks that are either sitting with market makers or with individuals. Something to pay attention to. Is the product itself inherently a stupid product? No, provided we can get some clarity around clearing dynamics, right?

Yeah. Why don't they? XIV, it is creating a situation in which the market is increasingly dependent upon that provision of volatility on a daily basis. We don't really know what the market looks like if that fails to materialize, right? And if that, for example, were to happen, or the Fed were to suddenly say, okay, let's regulate this market and we're going to require people to post a certain quantity of collateral, then suddenly the market structure could change in a way that is unanticipated, drive a huge spike in the VIX as people move back to hedging in traditional ways, for example. And you think our futures folks here in Chicago

would have figured out like, hey, let's offer these. We have the margin mechanism, right? They have the instant, the same day clearing abilities. Yeah. So I would think that to my knowledge, that's not been proposed yet. And by the way, I can be wrong on some of these things. The industry is very good. The people in the industry are very talented. And so other people are clearly aware of these issues and probably likely moving towards negotiated solutions on this stuff. With that said, we haven't seen it come forward yet. Right. And for sure, Citadels and Susquehannas know their exposures. As I said, they are exceptionally good. Craig, any other thoughts? And then I'm going to let Mike take a quick crypto victory lap if he wants, but we'll see how he thinks about

that. Yeah. I just wanted to share just one more chart here. So this shows the portion of volume for zero-day options as a percentage of total volume. And then this blue line here shows the percentage of those 30 day contracts volume out of total volume. And I think this chart really says a lot about how the hedging dynamics have shifted within, you know, within the SPX space. So if you, this is the two kind of separate phases I was talking about in the shifts of the zero day volumes. We saw it first happen in 2020 during the COVID crash. At the same time, we saw volumes drop at those 30 day contracts. And then again, in 2022, we saw the same sort of event. So I think there's a pretty close tie between the drop-off at those 30-day contracts and this increase we're seeing at these shorter-dated contracts.

And for listeners, the 30-day contract goes from about 40% of volume down to nine ish. So that's, uh, yeah, that's actually, um, that's going to be for the zero day auction. So it's actually going from about 8% of total volume, uh, down to about 2% of total volume. The 30 days. Got it. And the, and the zero DTs are going from eight to 45. Is that correct? Yeah. Pretty, pretty close to that. That's crazy.

But yeah, total mirror image essentially on this page of makes sense. So with the CBOE come out with one day VIX, does that make any sense? So they already have a nine day VIX. At Tier 1 Alpha, we basically create the calculation of a one day VIX, two day VIX. So we actually have the full curve a one-day VIX, two-day VIX. So we actually have the full curve laid out for people to look at. That in and of itself is actually a really fascinating picture. I know, Craig, if you can pull up an example of that just to close this out. It gives you a good sense for how the market is trying to price any individual event.

If we were to go back and look at a couple of the CPI prints, we're not going to have time to do that. You would see that that one day implied vol had gotten north of 40 in some situations. Today, you can see this looks very much like the overall VIX structure itself, where we're moving from sub-20 at basically the next report, initial jobless claims today, for example. You're moving from sub 20 to around 22 and a half, 23. This is all a three-day period. This is the VIX lead up to where the VIX itself is priced. So the VIX almost by definition is going to give you something that looks like that last point in this. And then you'll see much greater variability and volatility in the front contracts of this than you'll see in the vol surface recently.

And so, again, this goes back to this dynamic. A lot of people will talk about, in fixed income space, they'll say, well, would you want to buy a 30-year bond? Or why would you want to buy a 10-year bond when a two-year bond or a three-month bond offers higher yield right now, for example, due to the inversion of the curve? Well, one of the reasons is because of reinvestment risk. If all hell breaks loose tomorrow under this framework, it's going to be almost impossible to hedge. It's just mechanically, the hedging of that event's going to be almost impossible to hedge, right? Like it's just mechanically the hedging of that event is going to be too late. So unless you can time it perfectly, unless you happen to know that the ISM non-manufacturing that's going to print in a

couple of days is like the event, right? It becomes very difficult to price the sort of systemic risks of a traditional bear market in this sort of framework. So again, it just becomes one of these things that matters because people don't often understand the mechanics of what's happening below the surface. We've heard all sorts of nonsense around financial conditions easing. We would point directly to things like this as having driven a lot of those perceptions. And they're for-profit exchanges though. So to me, and that's interesting too, if the CBOE of like, oops, hopefully we didn't kill the VIX golden goose by introducing the zero DTE golden goose. So I bet the VIX department is probably over there going, hey, we need some more volume in VIX futures. Let's do one day VIX

futures or nine day VIX futures. Well, it's going to be interesting to see if that's the case. If we continue to expand this stuff, the market becomes increasingly sensitive to gamma, going back to the gamma-geddon type dynamic. Anything that's happening within a day or two, you can basically just think of as a coin flip, right? And an option with zero data expiry can move from zero delta to 100 delta in the blink of an eye. And that can cause huge demand for volumes at the futures level. Again, we know that futures are offering far less liquidity than they've offered in the

past, certainly relative to the level of the S&P itself. All of this is happening in the context of the higher inelasticity, that large change in price versus supplier demand that's occurring with greater and greater utilization of systematic and passive strategies. To steal the Nassim Taleb dynamic, this is fragility, not anti-fragility. Awesome. I think we'll leave it there unless you guys got anything else. I think this is fantastic. Thank you so much for having us. I wanted, Mike. I really appreciate it.

The crypto victory lap. You don't want to... I'm not sure that there, I mean, I'm not sure that there is a crypto victory lap at this point. I You don't want to... discovered that there was gambling in the casino that was happening in a fraudulent and unregulated fashion. We're shocked, absolutely shocked. It does feel, as I've said elsewhere, that Bitcoin is dead. It just doesn't know it yet. We've got a little bit of suspended animation going on here. Until I actually see these things die, or until I see Bitcoin die, I'm not going to take that victory lap. But I also just want to highlight that everything that we're talking about, right? Again, remember the discussion that we were having around clearing in T plus three versus clearing instantaneously. There's truth in every fraud. There has to be, right? If I go out

and I just make ridiculous statements in general, people are going to ignore it. But when you have the genuine need for it, there will be things that emerge around it. I just don't think it's Bitcoin. I don't see how that system works. Love it. Well, thanks so much. Thanks, Mike. Thanks, Craig. Go check out tier1alpha.com and get that newsletter so you can keep up to date on all this. And we'll talk to you guys soon. Good luck moving to the East Coast, Mike. Thank you very much. I appreciate it.

All right. We'll talk to you guys soon. Thanks so much. Take care. Thank you. Okay, that's the pod. Thanks to Craig Peterson and Tier 1 Alpha. Thanks to Mike Green.

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